Today’s guest post is from Torey Guingrich, a Project Manager at Source One Management Services, who focuses on helping global companies drive greater value from their expenditures.
I sometimes hear clients say, “We are leaning towards Vendor ABC because they don’t make us sign a contract“. In most cases, Vendor ABC does have a contract (or something acting as an agreement such as a letter of authorization, etc.); it is just based on a month-to-month term with no termination penalties/liability. Some companies have a knee-jerk reaction to avoid contracts, but while there appears to be less risk in a “no-term” contract, there are risks and rewards for both “term” and “no-term” agreements. Part of the strategic sourcing process is educating stakeholders on the different consequences of contract components such as term. When evaluating what type of contract or what term to leverage for your next agreement, consider these different aspects before negotiating a shorter (or longer) term contract.
Availability of Supply and Criticality to the Business:
Consider the supply management strategy of the category you are working with and where the product/service lands on the axes of availability of supply and criticality to the business. Based on the classification of purchasing strategy for the product or service to be sourced, you can determine if that strategy is best supported by a long-term partnership or a shorter-term, more flexible agreement structure. For example, if you are working within a category that is scarce in the market and critical to your operation, a long term contract is necessary to guarantee supply. On the other hand, if the products you are sourcing are widely available and can easily be replaced, it may be in your best interest to forego a term agreement.
One of the reasons why many companies opt for longer term contracts is to gain deeper discounts and ensure negotiated pricing is held for a period of time. When entering a contract, pay attention to the language around pricing and the supplier’s ability to change that pricing. Month-to-month contracts typically give the supplier the opportunity to raise prices; if you are purchasing in a market with downward pricing pressure, ensure that language also allows price reductions based on the market. Having a short-term contract in a market under pricing pressure may prompt suppliers to reduce pricing to prevent you from moving to a competitor. Likewise, when a market is trending up in cost (whether it be from decreased competition, increased maintenance costs, etc.) it may be prudent to lock in pricing with a long term contract. Depending on the industry, suppliers may offer signing bonuses, rebates, or other incentives when you sign a long term contract; these should be in addition to more competitive pricing in the contract.
Month-to-month contracts can be very appealing because in theory they allow you to simply change to another vendor if you are unhappy with your incumbent. There are certainly plenty of goods or services where companies are able to be vendor agnostic, but there are other categories where the cost to change is substantial. Likely, changing suppliers will (and should) involve a sourcing activity, e.g. RFP or RFQ, and thorough review of other suppliers in the market. After a new supplier is chosen, the transition process can be a relatively simple for some products or services, e.g. ordering IT accessories from another reseller, but can get more complex for others, e.g. migrating network services to a new carrier. If you are unhappy with the current supplier and chose to change, you will still need to rely on them to some degree during the changeover period. Be sure to consider the ease of change before jumping into a short or no term agreement under the assumption that you can quickly switch suppliers if needed.
The name of the game in short-term or no term contracts in flexibility. Companies may elect to pay slightly higher pricing to have the flexibility to terminate services or purchasing whenever they see fit. This tends to surface when companies are considering technology changes; they have plans to migrate their services to a different technology or platform and the flexibility of a month-to-month contract allows them to change over as necessary without penalty. This is all well and good, but before entering a higher priced agreement or one that allows for pricing increases, consider your company’s track record on executing migration/change and truly exam the pricing risks that can come with flexibility. If the migration will be based on small, incremental change over time, it is likely you can still use a longer term agreement to your benefit. Also examine the reasons behind the company’s need for flexibility: if the concern is around certain SLAs or KPIs, you can try to add termination rights related to these performance levels and still operate under a term agreement.
As you contract for new and existing categories, don’t get stuck using a one-size-fits-all contracting pattern. Where changes occur in the market, category management strategy, or category roadmap, ensure that the contracts you put in place support those changes and allow your Procurement group to perform optimally.